13. rules versus discretion in monetary policy

13. rules versus discretion in monetary policy - Rules...

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Rules versus Discretion in Monetary Policy 9November2010 1 Reading Chapter 14 of Abel/Bernanke/Croushore Chapter 17 of Hall/Taylor 2L a g s i n t h e E f ects of Monetary policy The IS-LM model makes monetary policy look easy: Just change the money supply to move the economy to the best point possible. In fact, things are not quite like that in practice because of lags in the e f ects of policy. It takes a fairly long time for changes in monetary policy to have an impact on the economy even though the target interest rates could change quickly. That is, output and in f ation barely respond in the F rst instance after the change in money growth. The typical responses of the variables of interest to a negative shock to money supply are shown in F gure 2. Tighter monetary policy causes real GDP to decline sharply after about four months, with the full e f ect being felt about 16 to 20 months after the change in policy. In f ation responds even more slowly, remaining essentially unchanged for the F rst year, then declining somewhat. These long lags make it very di cult to use monetary policy to control the economy very precisely. Because of the lags, policy must be made based on forecasts of the future, but forecasts are often inaccurate. In view of such di culties, how should monetary policy be conducted? 3 The Case Against the Use of Monetary Policy to Stabilize Output Recall that in NCM, money is thought to be neutral, even in the short run and recessions are the symptoms of supply shocks. Attempting to F ght recessions 1
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Figure 1: Monetary policy Figure 2: The Impulse Responses of interest rate, output, and price 2
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only causes undesirable price instability. The appropriate goal of monetary policy should be exclusively geared towards maintaining price stability. An older school of thought in macroeconomics, known as the Monetarists, led by Milton Friedman, also argued that monetary policy should not be used as a tool to stabilize output f uctuations. As opposed to NCM, the monetarists believed that money is not neutral in the short run but can have signi F cant short—run real e f ects. Even so, Friedman argued that the use of monetary policy to stabilize output would only result in unnecessary output and price instabilities — the exact opposite of what Keynesian economists believed. The premise is based on a few propositions. Proposition 1 Monetary policy has powerful short-run e f ects on the real economy. In the longer run, however, changes in the money supply have their primary e f ect on the price level. This proposition comes from Friedman’s research with Anna Schwartz on mon- etary history of the USA. Friedman and other monetarists think that monetary policy is a main source of business cycle f uctuations. Proposition 2
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13. rules versus discretion in monetary policy - Rules...

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